Farr: Hu’s On First!

Chinese President Hu Jintao is in Washington this week meeting with President Obama and members of Congress. While the meetings are reportedly cordial, there isn’t much agreement economically.

No surprise.

Overnight, China reported economic growth of 9.8% with sharp increases in both industrial production and retail sales. This growth was above estimates and feared to be inflationary. It is likely that China became the world’s second largest economy last year (surpassing Japan) with a $6 trillion Gross Domestic Product.

China’s enviable growth is the focus of longstanding US criticism of the country’s unfair trade practices. Inexpensive labor, government controlled currency, and tariffs have helped to produce China’s remarkable growth. Keeping the Chinese yuanat an artificially low level makes Chinese goods and services less expensive relative to other countries’ goods and services. US government and business leaders argue for a more competitively priced currency that would be subject to free market influences. These criticisms are valid, in our opinion but are not the whole growth story.

Sam Diephuis | Getty Images

Beijing, China

China is an emerging economy.

While the world’s largest population of just over 1.3 billion people isn’t growing much, there is enormous economic growth within that population.

As China moves from a strictly Communist, agrarian society and culture, cities, capitalistic attitudes and a robust middle class are emerging. This growing middle class is consuming. Everything from computers, home furnishings and healthcare is attractive and in great demand. So while we can try to address the levelness of the playing field, there is no argument as to the awesome demographic power of economic advancement in such a large population.

Headwinds to domestic growth in the US are considerable. Our economist Keith B. Davis, CFA and I have been focusing on the deficit, debt and interest rates. Keith has been remarkably accurate in his assessment and forecasts for several years. (Remember our Marketwatch article from 2007) As we try to anticipate the future interest expense of a growing US debt and we adjust those costs higher for an increase in interest rates, we checked numbers from the Congressional Budget Office. The CBO projects the interest rate on the 10 year Treasury note to be 4.7% in 2012 and 5.9% by 2015. It is 3.4% today. Because these figures were based on a deficit that did not anticipate an extension of Bush tax rates and other factors, they may be understated.

A 6% yield on the 10 year Treasury note translates to mortgage rates of well over 7%. Housing is critical to our domestic economic recovery, and higher rates will impede the pace. While home sales are increasing, prices continue to fall. While it’s good that markets and inventories are beginning to clear, the price declines aren’t over. So far, home prices have fallen 29.6% since July 2006 according to the S&P Case/Shiller 20-City home price index. Further price declines will affect consumer spending and the pace of economic recovery.

A slower paced US recovery and burgeoning emerging markets have us focused on investing in large companies with exceptionally solid balance sheets that are exposed to and will benefit from growth in other world markets. Strong cash flow, limited debt, and decent dividends strike us as very attractive attributes as well.

Our focus in bond portfolios continues to be research intensive and defensive. The municipal bond market is very inefficient right now and rife with both risk and reward. Though somewhat self-serving, if there was ever a time for a professional bond manager, the time is now. We perform a thorough analysis on each security we purchase for clients. We are also keeping maturities relatively short in anticipation of an inevitable increase in inflation. Shorter maturities and deep research into each security we purchase for clients are producing a strong advantage.

On Tuesday February 8, I am flattered to join Dr. Jeffrey Lacker, President of the Federal Reserve Bank of Richmond, and former Senator Don Nickles, R from Oklahoma at the annual Economic Outlook at the University of Delaware. Jon Hilsenrath from The Wall Street Journal will moderate a discussion of the Economic, Political, and Market landscape for 2011. It should be a great, informative discussion. Subscribers and CNBC readers are invited free of charge, but attendance is near full. Please reserve your spot by emailing: economicforecast@lyonsinsurance.com

Michael K. Farr is President and majority owner of investment management firm Farr, Miller & Washington, LLC in Washington, D.C. Mr. Farr is a Contributor for CNBC television, and he is quoted regularly in the Wall Street Journal, Businessweek, USA Today, and many other publications. He has been in the investment business for over twenty years.